Property funds have been in the news heavily over the past fortnight, following the decision by a number of high profile equity-based commercial property funds — from Aviva and Henderson to Standard Life and M&G — to suspend investor withdrawals.
On the back of this, understandably, we have had a few advisers ask us whether the challenges currently facing equity-based commercial property funds might play out in other sorts of property investments, too.
Essentially, advisers have been querying whether debt-based property investing is exposed to current Brexit-related nerves in the same way as equity-based property investment? Is there likely to be contagion? Not in my opinion.
The primary reason for this stems from the basic structural differences between debt and equity. With equity-based property funds, both the value and liquidity of an investment are directly linked to the sale and value of the properties in the underlying portfolio.
So in the event of a run on the fund, as we have seen with commercial property funds in the first half of July, how much you get back and how quickly basically depends on what the underlying properties sell for and when. It’s that simple.
With debt, it’s different. Returns aren’t based primarily on the value of the property, but on the interest that a borrower pays on their loan. The property is only offered as security in the event of a default.
And that’s where the loan to value (LTV) ratio comes in. Essentially, the LTV provides a significant buffer against any potential capital loss resulting from the sale of the underlying asset if the borrower defaults.
Now we clearly can’t talk for other products of its kind, but the average LTV of the residential loans Dragonfly Property Finance has made for Octopus Choice investors, to date, is in the region of 62 per cent.
In other words, if the borrower were to default, current Octopus Choice investors would have a buffer of around 38 per cent between them and any loss of capital. Now I can’t predict the future, but historically, it’s certainly part of the reason we’ve managed to limit capital losses to less than 0.1 per cent on over £2bn of lending.
The LTV element of debt-based property investing therefore serves as a significant cushion against market conditions. Equity-based property funds, on the other hand, move much more closely with market sentiment. Which, as we have once again been reminded, is not always positive.
But equity-based property funds aren’t just more volatile — they’re arguably more illiquid, too. Once a fund has exhausted the cash reserves it maintains to facilitate outflows, accommodating withdrawal requests means selling properties.
This is far less the case with debt-based property investments, where the sale of property is only a worst-case scenario, and where secondary markets can exist to facilitate withdrawals. In the case of Octopus Choice, for example, investors looking to withdraw funds can sell their stake in individual loans to new investors – or back to Octopus – prior to the end of the loan terms.
In summary, we believe property remains a sound investment — Brexit or no Brexit. But how you invest in it has never been more important.
Short guide: Debt versus equity
1. While they may have more upside potential, equity-based funds are directly linked to the realisable value of the underlying property assets. Debt investing only uses the asset as security, with the LTV ratio offering headroom against any fall in its value.
2. When considering investing in property debt, what’s the capital preservation track record of the lender making the underlying loans? Whilst past performance doesn’t guarantee future results, always ask for their historical default rate. This is key.
3. Are there any additional mechanisms to provide extra liquidity? For example, some debt-based managers will use their own balance sheets to inject additional liquidity or invest alongside external investors to take, where necessary, the initial hit.
4. Does the product you’re considering primarily invest in commercial or residential property? Residential property tends to be less volatile and is also underpinned by a deep structural supply/demand imbalance.
5. Both are capital at risk investments – and some debt based property investing isn’t covered by the FSCS.
Mark Posniak is managing director of Dragonfly Property Finance – the lender behind Octopus Choice